The Primary Driver of GDP Growth Is a Strong Rule of Law

Putting laws on the books is relatively easy. Enforcing them is the true test of a society's character.

As we contemplate the Libor scandal in which banks manipulated for their own gain the key metric for global interest rates, or the murder of a dozen random movie goers by a gun-toting mad man, we are forced to confront this civilization's commitment to the rule of law.

In the Libor case it appears that those involved calculated the odds and decided that the risk justified the rewards. It is not yet clear for how many years this went on, but so far, only one bank CEO has lost his job - and he was very well paid for his efforts in the interim. Certainly the absence of any serious charges, let alone convictions regarding responsibility for the financial crisis confirms the sense that the law is no longer considered an impediment to personal initiative.

In the gun massacre case, a coalition of gun sellers allied with ideologues looking to score political advantage will negate any effort to rethink US gun laws.

The result of both cases is to reduce trust. The connection with economic trends is that businesses and individuals are not inclined to invest when they believe the system is designed to place the majority of them at a disadvantage. And an economy without trust and investment soon fails to be an economy. JL

Washington's Blog reports (Hat tip Yves Smith):

Economist Woody Brock says that a nation’s GDP growth is based mainly on whether or not it follows the rule of law.
Economist and investment adviser John Mauldin notes:

I had dinner with Dr. Woody Brock this evening in Rockport. We were discussing this issue and he mentioned that he had done a study based on analysis by an institution that looks at all sorts of “fuzzy” data, like how easy it is to start a business in a country, corporate taxes and business structures, levels of free trade and free markets, and the legal system. It turned out that the trait that was most positively correlated with GDP growth was strength of the rule of law. It is also one of the major factors that Niall Ferguson cites in his book Civilization as a reason for the ascendency of the West in the last 500 years, and a factor that helps explain why China is rising again as it emerges from chaos.

One of the very real problems we face is the growing feeling that the system is rigged against regular people in favor of “the bankers” or the 1%. And if we are honest with ourselves, we have to admit there is reason for that feeling. Things like LIBOR are structured with a very real potential for manipulation. When the facts come out, there is just one more reason not to trust the system. And if there is no trust, there is no system.

Dr. Brock is not alone. Economists have thoroughly documented that failure to enforce the rule of law leads to a loss of trust … which destroys economies.

This is true whether it is in the West, in Nigeria or any other country.

We’re Number … What?
Economic historian Niall Ferguson notes:

The World Economic Forum’s annual Global Competitiveness Index and, in particular, the Executive Opinion Survey on which it’s partly based … includes 15 measures of the rule of law, ranging from the protection of private property rights to the policing of corruption and the control of organised crime.

It’s an astonishing yet scarcely acknowledged fact that on no fewer than 15 out of 15, the United States now fares markedly worse than Hong Kong. In the Heritage Foundation’s Freedom Index, too, the U.S. ranks 21st in the world in terms of freedom from corruption, a considerable distance behind Hong Kong and Singapore. [Transparency International puts the U.S. at 24th.]

Perhaps the most compelling evidence of all comes from the World Bank’s Indicators on World Governance, which suggest that, since 1996, the United States has suffered a decline in the quality of its governance in three different dimensions: government effectiveness, regulatory quality and the control of corruption.

Compared with Germany or Hong Kong, the U.S. is manifestly slipping behind.

Indeed – as we’ve extensively documented – the rule of law is now as weak in the U.S. and UK as many countries which we would consider “rogue nations”. See this, this, this, this, this, this, this, this, this, this and this.

This is a sudden change. As famed Peruvian economist Hernando de Soto notes:

In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

How Did We Slip So Fast?
Of course, the repeal of the basic laws which enforced the rule of law among financial players is a part of the problem. Virtually everyone – other than those currently working for the big banks or on their payroll – is calling for reinstatement of the separation between banking and speculative gambling.

Free market libertarians – like everyone else – are demanding prosecution of criminal fraud using basic fraud laws. Yet the government has made it official policy not to prosecute fraud.

People have lost trust in the system, because government corruption is as widespread as Wall Street corruption … and many of those in power in D.C. have the same sociopathic traits as those they supposedly regulate on Wall Street.

And as Professor Ferguson notes, draconian national security laws are one of the main things undermining the rule of law:

We must pose the familiar question about how far our civil liberties have been eroded by the national security state – a process that in fact dates back almost a hundred years to the outbreak of the First World War and the passage of the 1914 Defence of the Realm Act. Recent debates about the protracted detention of terrorist suspects are in no way new. Somehow it’s always a choice between habeas corpus and hundreds of corpses.

Of course, many of this decades’ national security measures have not been taken to keep us safe in the “post-9/11 world” … indeed, many of them started before 9/11.

And America has been in a continuous declared state of national emergency since 9/11, and we are in a literally never-ending state of perpetual war. See this, this, this and this.

In fact, government has blown terrorism fears way out of proportion for political purposes, and “national security” powers have been used in many ways to exempt big Wall Street players from the rule of law rather than to do anything to protect us.

Is it any wonder that we’re still in an economic crisis?